Planning Your Rest-of-Life: How Much Money Do You Need?

"I've got $300,000 in my 401(k) plan. I have all the money I need to retire."

I often hear statements like that in various situations--at my workshops, at cocktail parties, from my clients. My response is always to ask, "From your $300,000, how much do you need to withdraw each year to cover your living expenses?"

"I dunno--I'll just take out what I need. Three hundred grand is a lot of money--I guess it should last."

Guessing is not an indication of good planning! But occasionally I get an answer like this:

"About $30,000 per year."

The people who respond like this are often surprised to hear me say, "If you spend $30,000 each year, after 10 years, most likely your $300,000 will be gone. Then you either need to die or go back to work."

"Huh? What about the magic of compound interest?"

"The operative word here is 'magic.' Do you believe in magic? Because you'll need to if you think that money will last for your lifetime. Compound interest isn't magic, and it won't bail you out."

So how much money do you need to retire comfortably? I get asked this critical question frequently at my presentations and workshops. People want a neat and tidy number or formula; unfortunately, not much in life is neat and tidy, particularly when it comes to retirement planning.

The good news is, there are a few different ways to answer this question. The first way uses financial planning techniques to estimate your lifetime retirement income and make sure it covers your living expenses for the rest of your life. That's the subject of this newsletter.

The second way to answer this question is more profound: How much money do you really need to meet your basic living needs and be happy and fulfilled? Answering this question becomes crucial if you come up short or if your calculations say you can never retire. (Unfortunately, these two outcomes are more common these days, especially after the market meltdown.) Future newsletters will address this question.

A Simple Formula

So let's get back to the neat and tidy formula people want to help them determine how much they'll need to have in retirement savings. This simple formula is one you can use to manage your finances. It's easy to understand, though maybe a bit harder to implement.

I > E

I is your annual income, and E is your annual expenses. If you're planning to retire, you need to make this formula work for the rest of your life. The tricky part about managing this formula is that your I and E can change throughout your remaining years, sometimes for reasons beyond your control. And since most of us don't know how long we'll live, that only complicates the situation. But we still need to plan for this uncertainty.

A recent survey indicates that almost half of all older Americans don't do any retirement planning at all! The likely outcome of that lack of foresight is that they'll run out of money and need to return to work, perhaps in their 70s or 80s, a time when it might be difficult to find employment again.

I don't want this to happen to you or your loved ones. That's why I advocate using the simple I > E formula and some basic financial analyses. This will help you get in the ballpark with respect to having sufficient financial resources. From there, you can use the time-tested solution of fine-tuning your living expenses or working a little if you must to balance your I and E.

Targeting What You Need

When it comes to retirement, conventional financial wisdom relies on something called "replacement ratios," with statements like this: "To have a comfortable retirement, you need an income equal to 70% to 100% of your pay just before retirement." You might need less money during retirement than while you're employed because some of your expenses can go down, such as income and FICA taxes, work-related expenses and saving for retirement. On the other hand, you might need more money to account for the possibility of increased medical expenses.

While the replacement ratio method is a good place to start, it ignores major changes that can result from reduced expenses for dependent children, paying off your mortgage or downsizing major items such as your home and automobiles. It might also ignore increases in spending resulting from medical expenses, travel expenses or costs for dependent parents.

The replacement ratio method also assumes you'll want the same material standard of living during retirement as you had before. But this ignores the possibility that you might be willing to live on less as part of the bargain you make with yourself to get your retirement freedom. And this is a powerful possibility: As many people age, they're often less interested in material things and more interested in learning, hobbies, volunteering and spending time with friends and family.

So the first refinement to conventional wisdom is to prepare your own budget, reflecting how your living expenses might change during your retirement years. Don't skip this step! It's critical if you're going to determine a useful figure for the retirement income you need. You can do your own budgeting on a piece of paper, or you can use popular financial management software. AARP's website (www.aarp.org) contains simple calculators that can help you estimate your expenses in retirement. Don't forget to include a budget item for unexpected expenses, which can add up to 25% of your total annual budget.

If you don't have the time or inclination to do your own budgeting, then you can fall back on the conventional wisdom of replacement ratios to estimate your living expenses. Pick a ratio between 70% and 100%, based on your best guess or gut feelings, and apply this to your annual preretirement pay. If you don't have much discretionary income while you're working, it's safer to pick a number on the high side of this range. If you have a lot of discretionary income while you're working, you may have the luxury of estimating on the low side. While I don't really recommend using replacement ratios, it's better than doing no planning at all.

Once you have a guesstimate of your living expenses, the next step is to see how much income you might receive to cover these expenses.

Where Will You Get Your Retirement Income?

Most people have these four sources of retirement income:

Monthly income from Social Security
Traditional monthly pension income from work
Wages or self-employment income
Withdrawals from retirement savings such as IRAs, 401(k) plans, etc.

Getting estimates of the first two sources is fairly straightforward. The Social Security administration recently made significant upgrades to their website (www.ssa.gov) so you can now estimate your Social Security benefits using your own compensation history. You can also look at the statement that Social Security mails to you each year. This statement shows your estimated retirement income at age 62, your full retirement age (FRA) and age 70.

If you participate in a traditional defined benefit plan at work, you can usually get an estimate of your retirement income by asking your human resources department or plan administrator. Often you can estimate your income using an online calculator, or you might get a paper statement in the mail.

Make sure you use consistent retirement ages when adding up these two sources. For example, don't add your Social Security income at FRA (which is age 66 or 67 for most people) to your normal retirement income under a pension plan (which is often age 65).

When it comes to wages or self-employment income, it may seem straightforward to estimate your potential income, but there are a few complicating issues. First, you might not be able to get as much work as you need, or the income may be unpredictable. And second, while you might be able to work in your 60s or 70s, it might become more difficult in your 80s and beyond. Ideally, however, your first step is to see if you can make the numbers work with no wages at all.

The hardest part is estimating ...

How Much Retirement Savings Do You Need?

How much do you need to close the gap between the above sources of income--Social Security, pensions and wages--and your living expenses?

The answer depends on how close you are to retirement. If you're considering retiring in the next year to two, you should analyze and select the methods for converting your retirement savings into lifetime annual income and estimate how much income you'll receive. There are three different ways to do this, which I'll cover in the March newsletter.

If retirement is more than two or three years away for you, at the very least, you should get into the ballpark with respect to how much retirement savings you'll need. The simplest way is to use some crude rules of thumb. Suppose you need a given amount of annual retirement income. To estimate the retirement savings needed to generate this income, multiply your required annual income by:

20 if you're retiring in your mid to late 60s or later

25 if you're retiring in your late 50s or early 60s

33 if you want to be virtually certain you don't outlive your assets and you want to leave money to children or charities when you're gone

For instance, suppose you need an annual income of $20,000 to supplement your Social Security and pension income. To generate this annual income, you'll need retirement savings of:

$400,000 using the 20 multiplier

$500,000 using the 25 multiplier

$660,000 using the 33 multiplier

Looking Under the Hood

What's behind these multipliers? The resulting asset amounts are intended to generate a lifetime retirement income that has a low chance of depleting your assets and increases for inflation each year. I used actuarial and financial wisdom regarding prudent drawdown percentages and flipped them around. This wisdom suggests withdrawing 4% or 5% of beginning assets (depending on your age at retirement) and giving yourself increases for inflation each year. These drawdown percentages have roughly a one in 10 chance of outliving your assets (you can find detailed analyses and examples in my book Live Long & Prosper!) Flipping (or inverting) 4% and 5% results in multipliers of 25 and 20.

The multiplier of 33 assumes you want to live on just the interest and dividends of a portfolio balanced between stocks and bonds, and leave the principal to children or charities. This assumes your investment income will be about 3% per year, and flipping this percentage results in a multiplier of 33.

What Does This Mean to You?

As you can see, these are rough techniques that are just intended to get you started. It's really better to use retirement planning software or work with a financial planner to come up with more accurate figures. Estimating how much money you need is not an exact science, since you don't know how long you'll live and you need to prepare for unforeseen events that can happen many years in the future. However, using rough estimates is better than doing nothing, because they can at least get you in the ballpark of having enough money to generate a reliable source of lifetime income.

The resulting amounts of savings you need for retirement can be quite large--much beyond the scope of the average 401(k) account balances for older Americans, as described in my October 2008 newsletter. To make matters worse, most people don't have significant pensions or retiree medical benefits from work. I've seen the statistics: Millions of older working Americans are in this predicament, so they'll need careful, creative thinking and planning for their later years.

I'm reminded of the adage "nobody plans to fail, but many fail to plan." My hope is that you use the insights and inspirations in these newsletters to plan for these significant challenges. Having a good plan gives you the confidence to enjoy a healthy, meaningful rest-of-life.

P.S. Keep an eye out for my March newsletter, which will cover the critical issue of converting retirement savings to income.